Is the problem that they are too high? The Washington Post reports today on anger in Congress and elsewhere at the size of bankers’ bonuses. NY AG Andrew Cuomo’s office released a report yesterday with the unsubtle title, “No Rhyme or Reason: The ‘Heads I Win, Tails You Lose’ Bank Bonus Culture.”. According the Post’s account:
Cuomo’s investigation into pay practices at Wall Street’s largest firms found that nearly 4,800 executives and other employees were each awarded at least $1 million. Of those, more than 900 worked for Bank of America and Citigroup, which have been among the largest recipients of government bailout funds.
This latest report about Wall Street bonuses turned up the heat on lawmakers and regulators, who have been weighing how to rein in compensation practices that banking executives themselves admit contributed to the worst financial crisis in decades. The House is set to vote Friday on legislation that would give regulators authority to prohibit pay practices that they deem inappropriate and grant shareholders the right to cast non-binding votes on executive compensation.
Rep. Edolphus Townes, chair of the House Oversight and Government Reform Committee, announced hearings, and added, summing up pretty well the sense of outrage:
“A few months ago, they were facing bankruptcy. Then, after being bailed out, they’re giving huge bonuses,” Towns said. “I think the American people need some answers. With the economy being the way it is, and people suffering . . . how do you still do that?”
Are we headed to a system of government setting compensation limits for executives in banking and elsewhere? He who pays the piper, etc. If government and the taxpayer are going to be stuck holding the bill moral hazard when things go bad, then it is hard not think something like this. The ultimate insurers ought to be able to lower their costs if the taxpayers are essentially employing people. But the fundamental problems aren’t the cost of bankers – the fundamental issues are aligning incentives, how efficiently bankers allocate capital and credit (including limiting it and leverage) and their incentives to get it right, and the efficient levels of risk. The article goes on to quote some very smart people on the underlying incentives problems – I particularly recommend Harvard Law professor Lucian Bebchuk’s papers on the compensation problems. Bebchuk is quoted in the article:
“The details of design in many cases still fall short of what is necessary,” said Lucian Bebchuk, a Harvard law professor who has met with Obama administration officials to discuss pay principles. “There is substantial distance we need to go before we have effective tying of pay with long-term results.”
My general impression of the economics literature pre-crisis is that it tended to simplify and abstract away from the actual workings of institutions and agents on the inside. I think that has also been true of corporate finance law literature, as we have tended to assume that efficiency in markets takes care of itself, and forces efficiency within institutions. We are about to see a flood of literature taking account of “secondary” actors within financial institutions – and much of it, like Professor Bebchuk’s work, is likely to come from corporate finance legal scholars, who often have a better idea of how institutions work. For example, see this piece by Steven Schwarcz, downloadable at SSRN, on secondary tiers of managers and their incentives within financial institutions. The read this Wired piece by Felix Salmon, with this note on secondary management failures:
Bankers should have noted that very small changes in their underlying assumptions could result in very large changes in the correlation number. They also should have noticed that the results they were seeing were much less volatile than they should have been—which implied that the risk was being moved elsewhere. Where had the risk gone?
They didn’t know, or didn’t ask. One reason was that the outputs came from “black box” computer models and were hard to subject to a commonsense smell test. Another was that the quants, who should have been more aware of the copula’s weaknesses, weren’t the ones making the big asset-allocation decisions. Their managers, who made the actual calls, lacked the math skills to understand what the models were doing or how they worked. They could, however, understand something as simple as a single correlation number. That was the problem.
(In a later post, I want to take up something at a more abstract level, something for which Lucian Bebchuk’s papers have been illuminating for me, along with the writings of Duke Law School’s Deborah DeMott – the need to re-enshrine “agency” as a body of finance law, and the need for economists to find ways to absorb it into their assumptions and their models, and not merely as a weird, special case of contract.)